According to Jason Zweig in his very interesting book, Your Money & Your Brain, the wiring of our brains is responsible for some of the mistakes we make in our approach to investing. Zwieg covers a number of human tendencies that can be traced to brain activity, but I will focus here on what makes us want to keep chasing stocks that ultimately disappoint us. For a complete reviews, see the Canadian Capitalist's review.
The new science of neuroeconomics involves scanning subjects’ brains while they take part in experiments. By seeing which parts of the brain light up and how intensely they light up, researchers can tell a lot about how we’re wired.
It turns out that we’re more excited during the time leading up to a potential reward than we are to actually receive the reward. So, when a gambler plunks his money down on lucky number 7 at the roulette wheel, he’s more excited watching for the wheel to stop than he is to rake in his chips if he happens to win.
The amount of excitement in the gambler’s brain increases with the size of the potential win. This means that we’re attracted to buying stocks where we can imagine a big payoff. This makes penny stocks much more exciting and rewarding than big bank stocks, at least until the penny stock becomes worthless and the investor gives up hope.
But, things get worse. Our excitement level is dictated by the size of the potential reward and not the odds of collecting that reward. This explains lottery tickets. Watching the numbers being drawn is exciting because of the multi-million dollar payoff even though the odds of winning are negligible. So, even though we lost money on the last ten penny stocks we bought, the next one is just as exciting to own.
Things get even worse than this. The potential for reward is more exciting if the potential for loss is present. So, if your penny stock is a sure thing, it’s less exciting than if you might lose all your money.
If ever there was an activity that requires people to remain calm and unemotional to succeed, it is investing.